AP Macroeconomics

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AP Macroeconomics

• Consumption Saving

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Disposable Income (DI)

• Income after taxes or net income
• DI Gross Income - Taxes

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2 Choices

• With disposable income, households can either
• Consume (spend money on goods services)
• Save (not spend money on goods services)

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Consumption

• Household spending
• The ability to consume is constrained by
• The amount of disposable income
• The propensity to save
• Do households consume if DI 0?
• Autonomous consumption
• Dissaving
• APC C/DI DI that is spent

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Saving

• Household NOT spending
• The ability to save is constrained by
• The amount of disposable income
• The propensity to consume
• Do households save if DI 0?
• NO
• APS S/DI DI that is not spent

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APC APS

• APC APS 1
• 1 APC APS
• 1 APS APC
• APC gt 1 . Dissaving
• -APS . Dissaving

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MPC MPS

• Marginal Propensity to Consume
• ?C/?DI
• of every extra dollar earned that is spent
• Marginal Propensity to Save
• ?S/?DI
• of every extra dollar earned that is saved
• MPC MPS 1
• 1 MPC MPS
• 1 MPS MPC

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Determinants of C S

• Wealth
• Increased wealth . Inc. C Dec. S
• Decreased wealth . Dec. C Inc. S
• Expectations
• Positive . Inc C Dec S
• Negative . Dec C Inc S
• Household Debt
• High Debt . Dec C Inc S
• Low Debt . Inc C Dec S
• Taxes
• Taxes Inc . Dec C Dec S
• Taxes Dec . Inc C Inc S

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• Fun!!! With the MPC, MPS, and Multipliers

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Disposable Income

• Net Income
• Paycheck
• After-tax income

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Marginal Propensity to Consume (MPC)

• The fraction of any change in disposable income
  that is consumed.
• MPC Change in Consumption
• Change in Disposable Income
• MPC ?C/?DI

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Marginal Propensity to Save (MPS)

• The fraction of any change in disposable income
  that is saved.
• MPS Change in Savings
• Change in Disposable Income
• MPS ?S/?DI

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Marginal Propensities

• MPC MPS 1
• . MPC 1 MPS
• . MPS 1 MPC
• Remember, people do two things with their
  disposable income, consume it or save it!

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The Spending Multiplier Effect

• An initial change in spending (C, IG, G, XN)
  causes a larger change in aggregate spending, or
  Aggregate Demand (AD).
• Multiplier Change in AD
• Change in Spending
• Multiplier ? AD/? C, I, G, or X

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The Spending Multiplier Effect

• Why does this happen?
• Expenditures and income flow continuously which
  sets off a spending increase in the economy.

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The Spending Multiplier Effect

• Ex. If the government increases defense spending
  by 1 Billion, then defense contractors will hire
  and pay more workers, which will increase
  aggregate spending by more than the original 1
  Billion.

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Calculating the Spending Multiplier

• The Spending Multiplier can be calculated from
  the MPC or the MPS.
• Multiplier 1/1-MPC or 1/MPS
• Multipliers are () when there is an increase in
  spending and () when there is a decrease

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Calculating the Tax Multiplier

• When the government taxes, the multiplier works
  in reverse
• Why?
• Because now money is leaving the circular flow
• Tax Multiplier (note its negative)
• -MPC/1-MPC or -MPC/MPS
• If there is a tax-CUT, then the multiplier is ,
  because there is now more money in the circular
  flow

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MPS, MPC, Multipliers

• Ex. Assume U.S. citizens spend 90 for every
  extra 1 they earn. Further assume that the real
  interest rate (r) decreases, causing a 50
  billion increase in gross private investment.
  Calculate the effect of a 50 billion increase in
  IG on U.S. Aggregate Demand (AD).
• Step 1 Calculate the MPC and MPS
• MPC ?C/?DI .9/1 .9
• MPS 1 MPC .10
• Step 2 Determine which multiplier to use, and
  whether its or -
• The problem mentions an increase in ? IG . use a
  () spending multiplier
• Step 3 Calculate the Spending and/or Tax
  Multiplier
• 1/MPS 1/.10 10
• Step 4 Calculate the Change in AD
• (? C, IG, G, or XN) Spending Multiplier
• (50 billion ? IG) (10) 500 billion ?AD

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MPS, MPC, Multipliers

• Ex. Assume Germany raises taxes on its citizens
  by 200 billion . Furthermore, assume that
  Germans save 25 of the change in their
  disposable income. Calculate the effect the 200
  billion change in taxes on the German economy.
• Step 1 Calculate the MPC and MPS
• MPS 25(given in the problem) .25
• MPC 1 MPS 1 - .25 .75
• Step 2 Determine which multiplier to use, and
  whether its or -
• The problem mentions an increase in T . use (-)
  tax multiplier
• Step 3 Calculate the Spending and/or Tax
  Multiplier
• -MPC/MPS -.75/.25 -3
• Step 4 Calculate the Change in AD
• (? Tax) Tax Multiplier
• (200 billion ? T) (-3) -600 billion ? in
  AD

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MPS, MPC, Multipliers

• Ex. Assume the Japanese spend 4/5 of their
  disposable income. Furthermore, assume that the
  Japanese government increases its spending by 50
  trillion and in order to maintain a balanced
  budget simultaneously increases taxes by 50
  trillion. Calculate the effect the 50 trillion
  change in government spending and 50 trillion
  change in taxes on Japanese Aggregate Demand.
• Step 1 Calculate the MPC and MPS
• MPC 4/5 (given in the problem) .80
• MPS 1 MPC 1 - .80 .20
• Step 2 Determine which multiplier to use, and
  whether its or -
• The problem mentions an increase in G and an
  increase in T . combine a () spending with a
  () tax multiplier
• Step 3 Calculate the Spending and Tax
  Multipliers
• Spending Multiplier 1/MPS 1/.20 5
• Tax Multiplier -MPC/MPS -.80/.20 -4
• Step 4 Calculate the Change in AD
• ? G Spending Multiplier ? T Tax
  Multiplier
• (50 trillion ? G) 5 (50 trillion ? T)
  -4
• 250 trillion - 200
  trillion 50 trillion ? AD

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The Balanced Budget Multiplier

• That last problem was a pain, wasnt it?
• Remember when Government Spending increases are
  matched with an equal size increase in taxes,
  that the change ends up being to the change in
  Government spending
• Why?
• 1/MPS -MPC/MPS 1- MPC/MPS MPS/MPS 1
• The balanced budget multiplier always 1

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2008 FRQ

• 1. Assume the United States economy is operating
  at full-employment output and the government has
  a balanced budget. A drop in consumer confidence
  reduces consumption spending, causing the economy
  to enter into a recession.
• (a) Using a correctly labeled graph of the
  short-run Phillips curve, show the effect of the
  decrease in
• consumption spending. Label the initial position
  A and the new position B.
• (b) What is the impact of the recession on the
  federal budget? Explain.
• (c) Assume that current real gross domestic
  product falls short of full-employment output by
  500 billion and the marginal propensity to
  consume is 0.8.
• (i) Calculate the minimum increase in government
  spending that could bring about full employment.
• (ii) Assume that instead of increasing government
  spending, the government decides to reduce
  personal
• income taxes. Will the reduction in personal
  income taxes required to achieve full employment
  be
• larger than or smaller than the government
  spending change you calculated in part (c)(i) ?
  Explain
• why.
• (d) Using a correctly labeled graph of the
  loanable funds market, show the impact of the
  increased government
• spending on the real interest rate in the
  economy.
• (e) How will the real interest rate change in
  part (d) affect the growth rate of the United
  States economy?

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2008 FRQ Rubric

• One point is earned for correctly calculating the
  increase in government purchases
• C. (i) Change in G Recessionary gap/Multiplier
  (500/5) 100.
• (ii) One point is earned for stating that a
  larger reduction in personal income taxes is
  required than the 100 billion increase in
  government spending.
• One point is earned for explaining that
  households do not spend all of the initial
  increase in disposable income caused by a tax
  reduction, or that the tax multiplier is smaller
  than the government spending multiplier.

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Keynes

• The Keynesian multiplier effect is theoretically
  predictable if, among other things
• (a) the marginal propensity to consume is stable
  and known.
• (b) full employment characterizes the economy.
• (c) aggregate supply creates aggregate demand.
• (d) interest rates are flexible.

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The equation for the simple Keynesian multiplier
is

• ?Y . (MPC/S) 1. (where S the rate of
  savings).
• ?Y . (1-MPC)MPPL.
• (c) ?Y 1/(1-APC).
• (d) ?Y 1/(1-MPC).